Unit 11 – Adjusting the Books

Unit 11 – Adjusting the Books

Introducing Adjustments• Not enough – (Debits = Credits)• They must also be accurate.

• Many transactions begin in one accounting period, but continue to have an effect for several more accounting periods.

• Adjustments: are accounting changes recorded to ensure that all account balances are correct.– Purpose: to ensure that the financial statements are accurate.– Ex: Employees who work overtime or earn bonuses (not recorded by

end of fiscal period)• Expenses will be too low (Salaries Expense does not include overtime)• Liabilities will be incorrect (debt owing to workers – Salaries Payable will not be

shown on the balance sheet)

Prepaid Expenses• Are expense payments made in advance.

– Assets (rent, insurance, and supplies)– Items of value owned until they are used up or no longer have

value.• Example (Supplies)

– Assets as long as they are owned and unused.– Once used – no value – asset to an expense.

• “Adjusting entries” are recorded when financial statements are prepared to ensure their accuracy. (even though these changes occur on a regular basis)

• Conversion of prepaid assets to expenses.

Ex: Prepaid Rent

• Requirement of office rent of $1700 to be paid in advance for 3 months. (Apr – June)– Rent expense not debited– Account called Prepaid Rent is debited– At the end of April

• Prepaid rent (asset valued at $3400)• (1/3 of asset has been used)

• This adjusting entry has two effects:– It records Rent Expense of $1700 for April– It decreases Prepaid Rent by $1700

Ex: Prepaid Rent

Apr. 30 Rent Expense 170000

Prepaid Rent 170000

To record rent expense for April

Adjusting Entry

T-Accounts

Prepaid Rent

Apr.1 5 100Balance 3 400

Apr.30 1 700

Rent Expense

Apr.30 1 700

Balance Sheet $3400

Income Statement $1700

If not made: Expenses (too low), Net income (too high), Assets (too high)

Ex: Supplies (prepaid expense)

• Each working day, small amounts of supplies are used up. (only adjusted before financial statements are prepared)

• April 30th – count of all supplies remaining– $600 worth of unused supplies. (original $700)

Total supplies purchasedLess: Supplies leftSupplies used

$700 600$100

Ex: Supplies

Apr. 30 Supplies Expense 100.00

Supplies 100.00

To adjust the supplies account and to record the supplies expense for the month

Adjusting Entry

T-Accounts

Supplies

Apr.1 700Balance 600

Apr.30 100

Supplies Expense

Apr.30 100

Balance Sheet $600

Income Statement $100

Ex: Prepaid Insurance

• April 1st – Insurance policy $720 for one year– Covers fire, theft, and accidental damage to all office

furniture and equipment

• At the end of April, one month’s insurance has been used and must be recorded as an expense.

• The cost of one month’s insurance is (1/12) of $720, or $60.

Ex: Prepaid Insurance

Apr. 30 Insurance Expense 60.00

Prepaid Insurance 60.00

To record one month’s insurance expense.

Adjusting Entry

T-Accounts

Prepaid Insurance

Apr.1 720Balance 660

Apr.30 60

Insurance Expense

Apr.30 60

Balance Sheet $660

Income Statement $60

Introducing Depreciation

• Expense: money spent on things used to produce revenue for a business

• Equipment used up in operating the business, its cost becomes an expense of the business.– Ex: Equipment purchased for $12 000

• Estimated shelf life ~ 5 years• After that time, it will be worthless. ($ spent will have been used up)• Loses value each year (not instantly worthless)• A portion of the cost of the equipment is assigned as an expense to

each year’s operation. (consistent with the matching principle)• Cost of using fixed assets during an accounting period to produce

revenue for that period…therefore shown as an expense on the income statement for that period.

Depreciation• Is the allocation of the cost of a fixed asset to the fiscal

periods in which it is used.– “Amortization”

• Ex: Initial cost of $12 000 spread over 5 years– Depreciation figure of $2400 per year.– Assumes that the equipment is worthless after 5 years and has

no scrap value or trade-in value.

• The Depreciation of using up of fixed assets is an expense of operating a business and is recorded on the income statement.

Ex: Equipment (Depreciation)

Dec. 31 Depreciation Expense - Equipment 2400.00

Accumulated Depreciation – Equip. 2400.00

To record depreciation for the year.

Adjusting Entry

T-Accounts

Accumulated Depreciation-Equipment

Dec. 31 2400

Depreciation Expense-Equipment

Dec. 31 2400

Balance Sheet $2 400

Income Statement $2 400

Equipment

Jan. 1 12 000

Balance Sheet $12 000

Ex: Equipment (Depreciation)

Management Consultant ServicesPartial Balance Sheet

December 31, 20-Fixed AssetsEquipmentLess: Accumulated Depreciation

$ 12 000 2 400 9 600

More Depreciation

• Method of spreading the cost of a fixed asset over the life of that asset.

• Converting cost into an expense• Separate accounts for each group of fixed

assets (Buildings, Equipment, Delivery Trucks)– Depreciation Expense account– Accumulated Depreciation account

• Assets cannot depreciate past 100%.

Why Accumulated Depreciation account?

Allows us to monitor two types of info:

1) Original cost of the equipment2) Total amount of depreciation recorded over

the years.

(instead of simply reducing the value of the equipment account on the balance sheet)

Valuation or Contra Accounts

• Offsets the value of another account.– Ex: Accumulated Depreciation

• Used to arrive at the value of an asset• Has a credit balance (opposite to the normal

debit balances found in most asset accounts)

• Book value: (Cost of an asset) – (Accumulated Depreciation)

Book value continued…

• Book value – value according to the books of the company.

• Actual value – amount received if the asset is sold

• …Depreciation is NOT valuation.

Straight – Line Method(Calculating Depreciation)

• Allocates the same amount of depreciation to each fiscal period.• Original cost – Salvage value = Total writeoff over the period the item is used.

Declining-Balance Method (Fixed Percentage)(Calculating Depreciation)

• Allocates a greater amount of depreciation to the first years of an asset’s life.– More realistic• An automobiles depreciation is greatest in its first year.

• Each year a fixed percent is charged.

Journal Entries – Declining-Balance Method

Year 1 Depreciation Expense – Equip. 2400.00

Accumulated Depreciation – Equip. 2400.00

To record the first year’s depreciation

The adjusting entry used for the declining-balance method of depreciation must show a different amount each year.

Year 2 Depreciation Expense – Equip. 1920.00

Accumulated Depreciation – Equip. 1920.00

To record the second year’s depreciation.

Depreciation & Income Taxes

• Income taxes in Canada– Declining-Balance Method is used.– “Capital Cost Allowance”

• Maximum rates of depreciation are set by the government.– For each class (buildings, machinery, trucks, etc.)– Rates vary from (4% - 100%)– 4% (Class 1) – bridges and airplane runways– 100% (Classes 12, 23, 25) – tools and dental instruments

that cost less than $200.

Depreciation & Income Taxes

More Depreciation & Taxes• Land is NOT depreciable. (unlimited life)

– Business cannot claim capital cost allowance on land.

• For income tax purposes, a business does not have to use depreciation expense (capital cost allowance) in a particular year.– Carry over to a year when the company is actually making a profit…

help reduce income taxes.

• As a result…the amount of depreciation used in a particular year is often determined by the estimated profits or losses and the estimated income tax.

Two sets of books

• Legal to have separate records of the same business results.

– One for themselves• Use straight-line method (feels its best)

– One for the government• Use declining-balance method

The Principle of Materiality

• Requires that information that could affect the decisions of the users of financial statements be included when the financial statements are prepared.

• Example: If a balance sheet includes an account receivable that the accountant knows the customer will never be able to pay, that information is material…in other words…it is important info that must be disclosed to the users or readers of the balance sheet.

The Principle of Conservatism

• Requires that, where there are acceptable alternative accounting treatments for an item, accountants choose the one that will result in lower net income and net assets.

• “Applying a conservative philosophy to the accounting process”